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CS Executive · Corporate Accounting and Financial Management · Capital Structure

According to the Net Income (NI) approach to capital structure, what happens to the overall cost of capital (Ko) as a firm increases the proportion of debt, assuming cost of debt is lower than cost of equity and both remain constant?

Under the Net Income approach, cost of equity and cost of debt are constant, so more cheap debt lowers the weighted average cost of capital and raises firm value. The firm value is maximised at the highest possible debt proportion.

  1. AKo decreases and firm value increasesCorrect
  2. BKo increases and firm value decreases
  3. CKo remains constant and firm value is unchanged
  4. DKo first falls and then rises, giving an optimum point

Explanation

Under the NI approach, Ke and Kd stay constant as leverage rises. Since cheaper debt gets a greater weight in the mix, the weighted average cost falls and value of the firm rises. The constant-Ko result belongs to the Net Operating Income approach and the U-shaped result to the traditional view.

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